Recent US growth figures seem to have re-energised naive Keynesians who, lacking any real evidence or credible prior theory for their case, leap upon anything that can justify policies that involve increasing government borrowing further. More sophisticated Keynesians have something to offer to the debate about how we can deal with sticky prices during a recession, but their voices are drowned out by their naive Keynesian allies.

There are three arguments that are worth examining here, two of which come from one of Larry Summers’ 2012 Davos speeches.

He suggested that an expansionary fiscal contraction was a moronic idea. This is not true. A country that borrows more money has to fund that borrowing. One would expect from prior theory that a country with well developed capital markets, an open economy and floating exchange rates would not have a significant positive fiscal multiplier. If a government borrows more, that borrowing has to be funded. Capital is attracted from other parts of the capital market, thus making it more difficult for business to fund its borrowing. Alternatively, capital is sucked in from overseas and the real exchange rate rises. This is not a moronic argument: it is borne out by the empirical evidence. For countries that are already highly indebted, the situation is worse. The more indebted a country is, the more likely it is that people will rein in their consumer spending if government spending increases because it will be known that the so-called fiscal expansion will have to be reversed rapidly with an increase in taxes. The best that can happen from a so-called fiscal expansion in current circumstances is a very temporary boost to growth, followed by a rapid slowdown as the brakes are put on just as we start crawling out of recession. Perhaps 2011 is the price we are paying for 2009.

Summers also suggested that no country had pulled out of the Great Depression except through leaving the Gold Standard or through rearmament. Leaving the Gold Standard involved loosening monetary policy – it had nothing to do with fiscal expansion. Indeed, the one country that tried a fiscal expansion to pull itself out of the Great Depression – albeit very erratically – had the longest Great Depression of any developed country. That country was the US. The UK, on the other hand, grew rapidly just after leaving the Gold Standard whilst never having a budget deficit of more than one per cent of national income. Fiscal policy simply did not enter into the equation. In the UK, the Great Depression was finished before Keynes published General Theory.

Thirdly, naive Keynesians are pointing to the relative performance of the US and UK economies – the former has been following the approved policies and the latter has not, according to them. Why do they not examine Germany, one wonders? Let’s come to Germany in a moment. UK and US unemployment rates are more-or-less identical – and this is quite unusual, the US rate is normally lower. So, certainly, the two unemployment rates do not point to the success of ‘fiscal expansion’. The US economy has grown more rapidly and is four per cent bigger relative to the ‘crash position’ of four years ago compared with the UK economy. However, US government spending is about ten per cent of GDP lower as we have imitated the sluggish continental countries by raising government spending to 50 per cent of national income. Most studies suggest that a one percentage point of GDP increase in government spending reduces growth by 0.1 per cent. The differences in government spending levels alone would therefore explain the relative differences in performance between the UK and US economies. Indeed, a difference in growth rates of one per cent per annum between the US and the EU is fairly typical and certainly not explained by the former’s attachment to Keynesian policies. Also, the eurozone crisis is not irrelevant to this debate – the crisis has affected UK growth to a far greater extent than US growth.

But, let’s put all this to one side and assume that the growth can only be explained by differences in fiscal policy. What are those differences? There aren’t any! US and UK government borrowing are more or less identical. And, as Jeremy Warner pointed out in the Telegraph on Saturday, the change in the government fiscal position has also been more-or-less identical after you take into account the spending behaviour of the states in the US. The argument that identical rates of unemployment, differing growth rates and identical fiscal balances and changes in those fiscal balances in two countries clearly demonstrate that higher government borrowing leads to higher growth is just silly. Oddly enough, of course, Germany seems to be booming with much lower government borrowing and, for the first time in a generation, has lower unemployment than either the UK or the US. None of this proves that government borrowing does not lead to higher growth but, it has to be said that our opponents in the economics profession are not running very sophisticated arguments.

Interestingly, though, Ed Balls does try to run a more sophisticated version of the Keynesian position – or rather a version laden with more sophistry. He argues that the economy is slowing in the UK ahead of the proposed fiscal retrenchment because people are preparing for it by reining in spending. If this argument is true, however, it suggests highly sophisticated behaviour on the part of households – exactly the sort of highly sophisticated behaviour that naive Keynesians assume away in their models in general and which would make Keynesian solutions irrelevant. Surely, if people are reducing spending today because they expect a fiscal retrenchment tomorrow, they would rein in their spending today if there were an unsustainable fiscal expansion today – in anticipation of the inevitable rise in taxes to pay for the borrowing. Balls is just running a version of Ricardian equivalence for when it suits him.

Of course, Keynesian economics is all about having your cake and eating it – but Ed Balls’ position certainly takes the biscuit.

Philip Booth is Academic and Research Director at the Institute of Economic Affairs and Professor of Finance, Public Policy and Ethics at St. Mary's University, Twickenham. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. Previously, Philip Booth worked for the Bank of England as an advisor on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs and on the editorial boards of various other academic journals. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

7 thoughts on “From naivety to sophistry – Keynesian arguments on both sides of the Atlantic”

1. Do Greek Keynesians argue that the ‘problem’ of the Greek economy is insufficient demand?

2. I continue to marvel, as we all refer back to the US Great Depression of 1929 to 1941, that people seem unaware of the Very Small Depression in the US in 1920-21, when, according to Murray Rothbard, President Harding cut tax rates and nominal wage-rates also fell. The whole thing was over in little more than a year — whereas the Great Depression lasted at least twelve years.

“Oddly enough, of course, Germany seems to be booming with much lower government borrowing and, for the first time in a generation, has lower unemployment than either the UK or the US.”

Ahem…

Both France and Germany posted better than expected figures, however. Economists had expected France to record a 0.2% fall, with German GDP seen as shrinking by 0.3%, but the data showed France grew by 0.2% and German GDP fell by 0.2% over the period.

Also… “If a government borrows more, that borrowing has to be funded. Capital is attracted from other parts of the capital market, thus making it more difficult for business to fund its borrowing. Alternatively, capital is sucked in from overseas and the real exchange rate rises. This is not a moronic argument”…

It is a moronic argument when an economy is depressed because there are idle resources available: there is a free lunch in the form of more output if total expenditures increase to bring those idle resources into productive work. The problem of crowding out is also reduced when interest rates are at zero. Monetary stimulus is probably best, but monetary plus fiscal is also very likely to work. Fiscal stimulus alone, in a depressed economy, is also work a shot for reasons you seem to have completely skated around.

Left outside – yes, I omitted to mention the most recent German growth figures, but do you think that really changes the argument and do you not think that German exposure to the eurozone is the real problem here? I debated the welfare state in parliament recently and all the leftists there were telling me the Germany was going great guns after the crash because it had a more egalitarian society (this was before Christmas) – are the arguments going to change now? Getting back to open economies on floating exchange rates, which is really what I am focusing on (the issues in the eurozone are, admit, more complex)…I am sorry, but it is not a moronic argument. There is empirical evidence on this matter. It is disputed, of course (otherwise the argument would be closed). But, are you arguing that all those economists who come up with very, very low fiscal multipliers for indebted open economies with floating exchange rates are morons? It happens that the theory matches the evidence on this one – as I see it. Total expenditures do not necessarily increase when you allow for the fact that government borrowing has to be funded and that people might anticipate future tax increases. Also, it is only short-term interest rates that are zero – the government does not borrow at short-term interest rates. Fiscal stimulus financed through the monetary system is not really fiscal stimulus as such – it is monetary stimulus.

@LeftOutside – the reason that the economy is ‘depressed’ is because of the fiscal stimulus (and the overall level of government intervention/borrowing). But more seriously, for a start you should try reading WH Hutt’s The Theory of Idle Resources for an indication of the nonsense of these sorts of arguments. You can get it free on Mises.org.
I agree that the view that Germany is booming is erroneous on Dr Booth’s part – but the German economy has also been saddled with high levels of government debt. It is also deeply mired in the general European crisis brought on by excessive government borrowing. You are engaging in exactly the sort of naive Keynesianism that he, rightly, deplores.

US government spending is about ten per cent of GDP lower as we have imitated the sluggish continental countries by raising government spending to 50 per cent of national income. This to me seems contradictory? How can you have government spending / GDP 10% lower …raising government spending to 50% ?

NEWSLETTER SIGN UP

By continuing to use the site, you agree to the use of cookies. more information

The cookie settings on this website are set to "allow cookies" to give you the best browsing experience possible. If you continue to use this website without changing your cookie settings or you click "Accept" below then you are consenting to this.